CHAPTER

 
3
Government Microeconomic
Intervention
   
Methods and Effects of
 

Government Intervention in
Market
Prepared by Ms Viky
Course: AL-ECO
  
   
Today`s Discussion
• Impact and incidence of specific indirect taxes

• Impact and incidence of subsidies

• Direct provision of goods and services

• Maximum and minimum prices

• Buffer stock schemes

• Provision of information
  
   

Taxes
  
   
Taxes
Purpose of taxation:
To correct market failure
2. To redistribute income: impose taxes to reduce the
income and wealth of some groups in society and use the
money collected to increase the income and wealth of
other groups.
3. To pay for government spending: raise finance for their
expenditure programme
4. To manage the economy as a whole: influence economic
variables such unemployment.
  
   
Canons of Taxation
• Originally from economist Adam Smith in “An enquiry into
the Nature and Causes of the Wealth of Nation”
 
• Canons of Taxation: the main basic principle set to build
a good tax system.
  
   
Canons of Taxation

Canon of equality or equity Canon of certainty

Canons of Taxation (classic)

Canon of economy Canon of convenience

  
   
Canons of Taxation
• Canons of taxation
1. Canon of equity: those who can afford should pay more.
• Taxes should be levied according to the ability to pay of
the individual taxpayer.
• Based on social justice
• The high income group should pay higher tax, because
without the protection of the government authorities
(Police, Defence, etc.) they could not have earned and
enjoyed their income.
 
  
   
Canons of Taxation
• Canons of taxation
1. Canon of economy: revenue should be greater than the
cost of managed it.
▫ Proper tax administration to collect tax from public.
 

2. Canon of transparent: tax payers should know exactly

what they are paying.
▫ At the same time government is also certain about the amount
that will be collected.

 
  
   
Canons of Taxation
• Canons of taxation
1. Canon of convenience: easy to pay
• The means of payment and timing of payment should be
convenient to taxpayer.
• Land revenue is collected after the harvest has been
collected. This is the time when the cultivators can
conveniently pay.
• It is convenient to pay a tax when it is deducted at the time
of paying salaries
 
  
   
Taxes – Direct and Indirect

Tax

Direct Tax Indirect Tax

Specific Tax Ad valorem tax

  
   
Taxes – Direct and Indirect
• Direct tax: one that tax on income of people and firms
and cannot be avoided.
• Tax levied directly on individual or organisation.
▫ E.g. income tax, corporate tax (25%), capital gain tax (30%)
 
• Indirect tax: tax that is levied on goods or service.
▫ E.g. VAT on retail sales of goods and services, excise duties on
fuel, alcohol and tobacco products.
▫ Also includes council tax and business rates that charged
locally on the ownership of houses, apartments, and business
premises.
  
   
Taxes – Direct and Indirect
There are 2 types of indirect tax:
1. Ad valorem tax – tax which is charged as a given
proportion or percentage of the price.

Final price paid by consumer is inclusive of such tax

E.g. VAT, GST

 
2. Specific tax – tax that is fixed per unit

Tax on expenditure whereby it increases the price of

  
   
Taxes – Direct and Indirect

Excise duties imposed mostly on high-volume daily consumable

products to discourage public from the consumption, i.e. fuel,
alcohol, cigarettes
  
   
Activity 1
Malaysia urged to reintroduce GST
 
The Organisation for Economic Cooperation and Development has
recommended that the Goods and Services Tax (GST) be reintroduced in
Malaysia, as part of the country's medium-term fiscal strategy.
 
GST was replaced with the Sales Tax and Service Tax (SST) regime in
September 2018. Following the OECD's recommendation, minister in the Prime
Minister's Department (Economy) Datuk Seri Mustapa Mohamed indicated
that policymakers should consider reintroducing GST when the time was right.
 
Source: NST, August 17, 2021
 
Based on above scenario, do you think its wise for the government
to reintroduce GST?
  
   
Incidence of Tax
• Indirect taxes are widely use to discourage production and
consumption of demerit goods such as alcoholic drinks and
cigarettes.
• They tend to be passed on to consumers through price
increased.
• The imposition of tax increase producer’s cost of production
therefore shift supply leftward.
• The extent to which the producer is able to pass on the tax
by raising the price depends on the PED of the product.
   16
   
Incidence of Tax
Effect of Taxes on Cigarettes

Price Original After Tax

S1
Demand – DD Demand – DD
Supply – S0 Supply – S1
Eq. Price – 12 Eq. Price – 14
Tax of RM4 S0
Eq. Quantity - 400 Eq. Quantity - 200

14
  Total government revenue from tax
12 = 4 X 200 = 800
  (Total Area Shaded)
10
DD

200 400 Quantity

Borne by customer,
  Consumer`s share of tax

Borne by producer,
  Producer`s share of tax
   17
   
Incidence of Tax
EFFECT OF TAXES ON CONSUMERS AND PRODUCERS
 
Consumer Producer
Before Tax: Before Tax:
Pays RM 12 per carton Sells RM 12 per carton
After Tax: After Tax:
Pays RM 14 per carton Sells RM 14 per carton
However, sellers pay RM4 to the
government.
RM14 – RM4 = RM10
Burden of Tax: Burden of Tax:
RM 2 (RM14-RM12) RM 2 (RM12-RM10)
  
   
Incidence of Tax
• The imposition of $1 per quantity has only raise the price
by $0.70 and not full of $1, as the tax is unlikely to fall
totally on customer.
• The remaining $0.30 will be paid by producers.
• This is called incidence of tax.
• Incidence: the extent to which the tax burden is borne by
producer or the consumer or both.
▫ Measures the burden of tax upon tax payer.
  
   
Incidence of Tax
Initial equilibrium  
Price

New equilibrium  

Tax paid by consumer  

Tax paid by producer  

Government revenue  

Quantity
The incidence of tax
  
   
Incidence of Tax
Initial equilibrium  
Price

New equilibrium  

Tax paid by consumer  

Tax paid by producer  

Government revenue  

Quantity

The incidence of tax – elastic demand

  
   
Incidence of Tax
Initial equilibrium  
Price

New equilibrium  

Tax paid by consumer  

Tax paid by producer  

Government revenue  

Quantity

The incidence of tax – inelastic demand

   22
   
Incidence of Tax
EFFECT OF PRICE ELASTICITY ON TAX BURDEN
 
• The equal sharing of the tax burden does not occur all the time
 
• The distribution of the tax burden between the buyer and the seller
depends on the elasticity of demand and supply
 
• There are various cases such as:
   - Perfectly inelastic demand; buyers pays entire tax
   - Perfectly elastic demand; sellers pays entire tax
   - Perfectly inelastic supply; sellers pays entire tax
   - Perfectly elastic supply; buyer pays entire tax
   - Demand more elastic than supply, seller pays more tax
   - Demand less elastic than supply, buyer pays more tax
 
 
  
   
Incidence of Tax
• When PED is elastic, it implies that ___________ are
more sensitive towards the price changes.
• Therefore the incidence of tax will be more on
__________.
• When PED is inelastic, it implies that consumers are less
sensitive towards the price changes and will not reduce
their consumption greatly even if prices rise.
• The tax burden by consumers is greater than tax burden by
producers. 
  
   
Incidence of Tax
• The government would rather place indirect taxes on
commodities where demand is _____________.
• The tax causes only a small fall in the quantity demanded
and total revenue from taxes is greater. 
• E.g. petrol, cigarette
  
   

Subsidy
  
   
Subsidy
• Subsidy is a direct payment made by government to the
producers of goods and services.
 
• Subsidies might given to:
▫ Keep down the market price of essential goods
▫ Encourage supplied of merit good and encourage greater
consumption of merit good
▫ Contribute to more equitable income distribution
▫ Encourage exports, reduce dependence on imports
 
  
   
Subsidy
Price

Quantity

Subsidy diagram
  
   
Subsidy
• Initial market equilibrium at ______
• Introduction of subsidy __________ producer’s cost of
production, supply curve shift  __________.
• New market equilibrium is at _________.
• New equilibrium price is _________, and new
equilibrium quantity is ___________.
   29
   
Subsidy
Effect of Subsidy on Rice

Price Original After Subsidy

S0
Demand – DD Demand – DD
Supply – S0 Supply – S1
Subsidy of RM10
S1
Eq. Price – 50 Eq. Price – 45
Eq. Quantity - 10 Eq. Quantity – 20

50
  Total subsidy by government = Total Area
45 Shaded
 
40
DD

10 20 Quantity

Enjoyed by customer,
  Consumer`s share of subsidy

Enjoyed by producer,
  Producer`s share of subsidy
   30
   
Subsidy
EFFECT OF SUBSIDY ON CONSUMERS AND PRODUCERS
 
Consumer Producer
Before Subsidy: Before Subsidy:
Pays RM 50 per unit of rice bag Sells RM 50 per unit of rice bag
After Subsidy: After Subsidy:
Pays RM 45 per unit of rice bag Sells RM 45 per unit of rice bag
However, sellers pay RM4 to the
government.
RM45 + RM10 = RM55
Subsidy Enjoyed: Subsidy Enjoyed:
RM 5 (RM50-RM45) RM 5 (RM55-RM50)
   31
   
Subsidy
EFFECT OF PRICE ELASTICITY ON SUBSIDIES
 
• The distribution of subsidy given by the government between the buyer
and seller depends on the elasticity of demand and supply
 
• There are various cases such as
Demand is more elastic (elastic) than supply, sellers benefits more
from the subsidy
(ii) Demand is less elastic (inelastic) than supply, buyers benefits more
from the subsidy
   32
   
Subsidy
Effect of Subsidy on Rice Bags

Price
S0

S1
Demand more elastic than supply,
50
buyer`s share of subsidy is RM 3,
47   seller`s share of subsidy is RM 7
DD
 
40

10 20 Quantity

Enjoyed by customer,
  Consumer`s share of subsidy

Enjoyed by producer,
  Producer`s share of subsidy
   33
   
Subsidy
Effect of Subsidy on Rice Bags

Price
S0

S1
Demand less elastic than supply,
buyer`s share of subsidy is RM 7,
50
seller`s share of subsidy is RM 3
 
43
 
40

DD

10 20 Quantity

Enjoyed by customer,
  Consumer`s share of subsidy

Enjoyed by producer,
  Producer`s share of subsidy
  
   
Subsidy
• Allocating subsidies from limited government revenue
interfere with the workings of market mechanism.
• These subsidies are blanket or lump sum payments
and unlike taxes on consumers, subsidies does not
linked to incomes and the ability to pay.
It is therefore necessary to access who benefits
from the subsidies.
  
   
Subsidy
• Staple food such as rice and cooking oil are subsidised in
developing economies, to provide relieve for the poorest
group in the economy.
▫ However subsidised prices are paid by all income groups,
many of who can afford to pay more.

▫ If subsidy is paid to producers, there is no incentive for

inefficient producers to improve.
  
   
Subsidy
• Public transport is heavily subsidised across the world.
• This is done to give low earners access to employment
opportunities, provide social mobility, reduce congestion
and reduce environment impact of traffic.
• These benefits, meanwhile are enjoyed by individuals and
community as a whole.
  
   
Activity 1
Using information from your own country where
possible, consider the benefits of the government
subsidising:
 
• poultry production
• long-distance rail services
• university education.
  
   

Direct Provision of
Goods and Services
  

Direct Provision of Goods and    

Services
• Another way of reducing inequalities in society is for
government to provide certain important service free of
charge to the public.
▫ Such services are financed through tax system.
 

• Lowest income group gain the most as a result of direct

provision of goods and services, thereby lowering
inequality.
  
   
Direct Provision of Goods and
Services
Common examples of direct provision are merit goods, such
as health care and education.
▫ The justification to provide such service is base on equity –
everyone should have access to certain level of health care and
education regardless of income.
 

UK has NHS almost free to all over 60 years but not so in

USA.
▫ They need to pay for Medicare insurance.
  
   
Direct Provision of Goods and Services
Advantage of direct provision:
 
 
 
Disadvantage of direct provision:
 
  
   
Activity 2 - Application
The National Health Service is the publicly funded healthcare
system in England, and one of the four National Health Service
systems in the United Kingdom. It is the second largest single-
payer healthcare system in the world after the Brazilian Sistema
Único de Saúde.

Outline some of the advantages and disadvantages of NHS

provision of healthcare:
  Advantages Disadvantages

   
  
 
Direct Provision of Goods and  

Services
• The main criticism is that market overprovides when
no direct charge is made.
 
• This leads to resources are not allocated efficiently.
 
• If a charge is made, demand is likely to fall.
 
  
   
Activity 3
For each of the public goods given below, justify whether or not
they should be provided by the government:

• Lighthouses
• City parks
• Libraries
• WiFi hotspots
• The military
• Flood defences
• TV channels
 
  
   

Maximum Price and

Minimum Price
  
   
Maximum Price
Maximum price (price ceiling): legal maximum on
the price at which a good or service can be sold and
market price must not exceed this price.

Valid in markets where the maximum price is below the

normal equilibrium price determined in a free market.

Government enforce maximum price for:

▫ Staple food, rents in certain types of housing, services
provided by utilities, transport fares.
  
   
Maximum Price
Price

Pe

Pmax Maximum price

Q1 Qe Q2 Quantity

Maximum price
  
   
Maximum Price
Market equilibrium in a free market is at PeQe.
Government impose maximum price at Pmax.
At Pmax, market supply at _________, market demand at
_________.
This leads to _________________.
As price cannot rise, continue to supply at ________.
▫ This is inefficient as too few resources are allocated.
  
   
Maximum Price
Impact of maximum price
Inefficiency / shortages: distort market equilibrium as
there is excess demand and shortages in supply for the
good or service.
Government impose maximum price on rented
accommodation could create homelessness, as shortages in
supply means some customer unable to get the product at
all.
  
   
Maximum Price
  
   
Maximum Price
Impact of maximum price
1. Existence of black market: due to excess demand, some
consumers are prepared to purchase at a higher price in
black market to get the good or service.
This creates incentives to develop black market where
people trade the good or service illegally.
E.g. market for sporting tickets, rock concerts.
  
   

Maximum Price
Impact of maximum price
Queue: people will have to queue to purchase the good or
service before it sells out.
Rationing as a mean of restricting demand – allocating
the good or service on a “first come first serve” basis.
Suppliers could also distribute the good or service only to
preferred customers.
  
   

Activity
 
1
Task
Can you work out the value/level of some real-world maximum
prices in this game?
• Energy price caps introduced in the UK in 2019, will be removed in what
year?
Since 2015, landlords in many German towns and cities can not set rent for
new tenants by more than how much above the average?
In 2019, the price of international mobile phone calls between callers based
in EU countries was capped at what rate per minute?
In 2015, a cap was placed on payday loans in the UK. What maximum
percentage are lenders allowed to charge per day (%)?
 
  
   

Minimum Price
Minimum price (price floor): legal minimum on the
price at which a good or service can be sold, market must
not go below this price.
Valid in markets where the minimum price is above the
normal equilibrium price determined in a free market.
Government enforce minimum price for:
▫ Demerit goods, wages in certain occupations usually low
skilled, certain types of imported goods to protect domestic
producers.
  
   

Minimum Price
Price

S
Pmin Minimum price

Pe

Q1 Qe Q2 Quantity

Minimum price
  
   
Minimum Price
• Market equilibrium in a free market is at PeQe.

• Government impose minimum price at Pmin.

• At Pmin, market supply is at _______, market demand is

at _______.

• This leads to ______________.

▫ As price cannot fall, supply restricted to Q1 – this is all

consumer can afford to buy.
  
   
Minimum Price
Impact of minimum price:

1. Over-supply in the market and leads to inefficient.

2. Higher prices for consumer

3. If consumers continue to buy at Q1 and producers are

supplying at Q2, producers will have the pressure to lower

the price back to Pe to clear the excess supply.

  
   

Activity 2
 
Task
Use the web to find out if there is a minimum wage in
your country. If there is, try to answer the following
questions.
 
• What is the level of the minimum wage?
• What age does it start at?
• Are there any exceptions where employers are allowed
to pay below the minimum wage?
 
 
  
Maximum and Minimum Price
Minimum Price
- Other name: Floor Price, Price
Support
- Price is not allowed to fall
- Also known as minimum price
- Surplus occurs
ADVANTAGES
- Protects producer`s income
- Higher wage rate
DISADVANTAGES
- Consumer`s pay more
- Waste of resources of production
- Creates unemployment
59
Maximum Price
- Other name: Ceiling Price, Price
Control
- Price is not allowed to rise
- Also known as maximum price
- Shortage occurs
ADVANTAGES
- Consumers purchases products at a
lower price
DISADVANTAGES
- Emergence of black market
- Reduces quantity produced
- Producers tend to receive illegal
payments from consumers
   60
   
Maximum and Minimum Price
Minimum Price Maximum Price

Price Price

Surplus S
S

P2
Min Price
P*
  P*  
Max Price
P2

D Shortage D

Quantity
Quantity
  
   

Buffer Stock Schemes

   62
   

Buffer Stock Schemes

• A government may operate a buffer stock to stabilize the price of metal,
mineral or an agricultural product that is non-perishable.
 
• A buffer stock is a store of a commodity

• Buy the commodity

when market prices are
threatening to push the
price below the lower To ensure that they do
limit not have to spend large
amounts on storing the
product or run out of
• Sell the commodity
money buying the
when market
product.
prices are
threatening to
raise the price
above the upper
Buffer stock limit
Price limits have to set close to the
managers
L/R equilibrium price
  
   

Provision of
Information
  
   
Provision of Information
• When there is asymmetric information, the
government provides information to allow people to
make informed decisions.
 
• They may also force companies to provide
information.
  
   
Provision of Information
Advantages:
 
• This helps consumers to act rationally, which allows
the market to work properly.
 
• It is best if the government uses this alongside other
policies . For example, it can make demand more
elastic in the long run and so help indirect taxes to
become more effective at reducing output.
  
   
Provision of Information
Disadvantages:
 
• This can be expensive for the government to do,
incurring an opportunity cost.
 
• The government themselves may not always have all
the information, so it may be difficult to inform
consumers.
 
• Consumers may not listen to the information
provided due to irrational behaviour.
  
   
Provision of Information
• Some examples of information provision are labels on
cigarette packages and information campaigns on
speeding, obesity, drinking and smoking.
 
• Consumer protection laws and industry standards help
to overcome problems relating to second hand
products.
 
• The ‘traffic light system’, where foods are rated green,
orange or red on calories, sugar, salt etc. helps to
easily show consumers the healthier options.
 
• Despite these information campaigns, many
  
   
Key Terms
Key Terms Explanation

Canons of Adam Smith`s criteria for a `good` tax

taxation  
Direct tax One that taxes the income of people and firms and cannot be
  avoided
Indirect tax A tax that is levied on goods and services
Incidence The extent to which the tax burden is borne by the producer or the
  consumer or both
Proportional One that takes the same proportion or percentage from all who
tax have to pay it
Progressive A tax that takes a higher percentage from those with higher
tax incomes
Regressive A tax that takes a greater percentage from those on lower incomes
tax  
  
   
Key Terms
Key Terms Explanation

Subsidy an incentive from the government to encourage producers or

sellers to produce more

Key Terms Explanation

Transfer A hand out or payment made by the government to certain

Payment members of the community
  
   
Key Terms
Key Terms Explanation

Market Where the free market does not make the best use of scarce
Failure resources
Regulation Various means by which government seeks to control production
and consumption
Taxes Charges imposed by government on incomes, profits and some types
of consumer goods and services to fund their expenditure
Maximum A price that is fixed; the market price must not exceed this price
price
Minimum A price that is fixed, the market price must not go below this price
price
  
   
Questions For Practice
a) Using examples, explain the difference between
a specific (or unit) tax and an ad valorem tax. [4]
 
b) Using a diagram, analyse the effects of an
increase in tax on:
i petrol [4]
ii alcohol drinks. [4]
 

 
 
 
  
   
Questions For Practice
Explain with an example the term subsidy. [3]
 
Discuss whether subsidies should be removed from
agricultural products in the EU and the US. [6]
 
 
 
 
 
  
   
Questions For Practice
What will cause the payment of a subsidy to firms to result
in the greatest increase in sales?
A. a shift in the demand curve to the right
B. a shift in the supply curve to the left
C. an elastic price elasticity of demand for the product
D. an inelastic price elasticity of supply for the product
  
   
Questions For Practice
Discuss the advantages and disadvantages of provision
of goods and services to the society. [6]
 
 
 
 
 
  
   
Questions For Practice
a) Distinguish between maximum and minimum
prices.[4]
 
b) Using a diagram, explain the effects of the
introduction of a minimum price for cotton on:
i cotton farmers [4]
ii clothing manufacturers. [4]